In a not-so-distant past, investors who were interested in pooled investments commonly purchased mutual funds, where they could capture the returns of a diversified portfolio using a single investment vehicle. Those funds, however, came with some limitations, among these the fact that positions in them can normally only be adjusted after market hours according to their net asset value (NAV).
Following a steep stock market crash in 1987, the U.S. Securities and Exchange Commission suggested the creation of a new type of investment vehicle. The goal was to allow investors, particularly institutional investors, to exchange fund portfolios during market hours so that they could avoid liquidity deficiencies that had been exacerbated by the introduction of automated trading.
Although it was only a suggestion made in an SEC report, some forward-looking investment managers took the idea to heart and not long after that the first ETFs appeared. The earliest successful ETF was launched in Canada in 1990, and the first ETF traded in the U.S. appeared a few years later, in 1993. They grew rapidly in popularity, and by 2015 some $2.2 trillion was invested in more than 4,000 ETFs around the globe.
How ETFs Are Used
Traditional mutual fund investors often adopt buy-and-hold strategies focused on the long-term value of assets and dividends paid by a mutual fund. However, ETFs can serve both long-term and short-term investment objectives. They are quoted like a stock, so ETFs can be bought, sold or even short-sold in intraday trading, by investors seeking short-term gains. And like traditional mutual funds, they can also be held for the long term as part of a growth strategy with a diversified portfolio.
Additionally, they can serve as the underlying instrument for derivatives, like futures and options. To buy or sell an ETF, a trader will need only a traditional retail brokerage account and to pay applicable trading commissions.
ETF Advantages And Disadvantages Compared To Mutual Funds
While traditional mutual fund shares are purchased directly from the fund, ETFs are bought and sold among investors on an exchange. Also, mutual funds are priced according to their NAV at the end of each trading session, whereas ETFs are priced according to market supply and demand.
Because of the way they are set up, traditional mutual funds often come with higher fees, often even to encourage a buy-and-hold strategy and discourage frequent trading. ETFs, with lower fees, may be traded frequently at a lower cost. Thus, a mutual fund and an ETF holding exactly the same securities can have different prices and different costs associated with trading.
Unlike mutual funds, ETFs can be purchased on margin and with price limit orders. While mutual funds can require high minimum investments, ETFs can be purchased in small amounts, allowing easier access for small investors. However, mutual funds may provide an advantage in trading commission costs, especially for re-investment of dividends, unless a broker allows for automatic dividend re-investment in ETFs without the payment of commissions.
ETF Tax Advantages Over Mutual Funds
ETFs can also be advantageous in terms of taxation. ETFs in general generate fewer "taxable events" than mutual funds. This is because mutual fund managers must often re-balance their funds by selling securities to offset shareholder redemptions or to re-allocate assets, creating capital gains tax liabilities that are passed on to shareholders.
By contrast, ETFs accommodate asset shifts by exchanging blocks of securities called "creation units" on a fair-value basis with large institutional investors known as "authorised participants." This process does not generate additional capital gains for ETF holders and can help keep tax costs lower.
Currency And Commodity ETFs
With their introduction, ETFs were structured under the rules of the 1940 Investment Company Act, which prohibited use of commodities and currencies. In 2004, however, the first funds were formulated using a legal structure outside of the scope of that act, allowing for trading of commodity and currency ETFs.
Since then, scores of currency and commodity ETFs have emerged, allowing investors to purchase these funds in place of the original assets. Traders who don't want to take a position directly in forex markets may consider currency ETFs to ride out a long-term currency trend or as a hedge against adverse currency movements that could destabilise a portfolio of international holdings. Similarly, commodity ETFs can offer traders a chance to take a position in key commodities markets without opening an account to trade directly on commodities exchanges.
In addition to equity, currency and commodity ETFs, there are also ETFs with bond holdings. Unlike individual bond holdings, which are traded on an over-the-counter basis and are highly sensitive to interest rate shifts, bond ETFs may offer investors more stability and ease of trading on securities exchanges.
Because of their inherent flexibility, ETFs have been used for a variety of both short-term and long-term investing objectives. Like mutual funds, they can be used to achieve diversification or to help target specific asset group allocations and weightings within a portfolio.
Additionally, they can be used for passive management strategies, when referenced to a particular index or in more active portfolio management, where assets are bought and sold according to shifts in their value. Further, they are also often used to improve portfolio tax efficiency or as short-term investments for large temporary cash positions.
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Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…